There are plenty of reasons to argue why real estate is the best investment to make: use of leverage, cash flow, appreciation, economies of scale (for us multi-family folk), etc., etc. Investment real estate is owned by the majority (maybe all?) of the richest people in the world. Real estate creates wealth, shelters wealth, and provides for a means to pass on wealth.

But there is something else that makes real estate worthwhile. This “something” is what creates the potential for building and generating wealth via real estate investments. It isn’t discussed often, but should be understood as I think it’s the main reason investors can prosper: market inefficiency.

Market inefficiency is the theory that the market prices of similar securities are not always accurately priced and tend to deviate from the true discounted value of their future cash flows. The phrase can also be used to refer to a market that is not operating efficiently — for example, markets where relatively low volume is traded.

Stock exchanges enable efficiencies in the buying and selling of shares of stock, and bond exchanges provide efficiencies for the buying and selling of bonds; then we have derivatives markets, futures markets, currency markets, and many more. Heck, even the markets for shares in private entities are relatively efficient due to secondary exchanges.

The real estate market is relatively inefficient compared to markets for other investment vehicles, but in my mind, the inefficiencies provide for the best reason to get into real estate investing. Leverage is a tool, and cash flow and appreciation are the result, but market inefficiency allows for investors to find profit opportunities, exploit these opportunities, and create value.

How to Analyze a Real Estate Deal

Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.

You see, Warren Buffett rocked it before the information age dawned on the United States. Buffett was an absolute genius at finding companies with a stock price way below market value. But the key piece of information that not many people know is that he was utilizing information and connections that not everyone had access to. This allowed him to identify value gaps between current market price and actual “book” price months, sometimes years, before Wall Street and the rest of the world’s investors caught on. Buffett was able to consume information about a company and determine the company’s strengths and weaknesses, as well as how he could potentially improve upon those weaknesses.

Once the information age rolled around, access to information slowly eroded Buffett’s ability to generate substantial returns. Don’t get me wrong, I still think Buffett is brilliant, and his funds perform quite well. But there isn’t much room for substantial value-add opportunities in the stock market today, mainly due to the fact that so many eyes are monitoring and consuming every piece of information released by companies.

Once people were able to access real time information for little to no cost, the value-add picking ability practically vanished. People still make great returns in the market, and analysts still have great picks. But now that everyone can easily gain access to the same information, the ability to identify a company whose stock price is substantially below its actual value becomes exponentially harder.

And this is one of the main reasons I love real estate. It’s a complicated business to learn, there are plenty of moving parts, financial information is difficult to consume and further understand, and you have very few eyes monitoring any one transaction. Not everyone has access to the same information, and even if they did, they don’t know how to digest it.

You Control the Analytics and the Operations

Being a thorough analyst in the real estate world will allow you to find deals where you can add a ton of value. Where other investors see substantial risk, you see a value-add opportunity. You may know how to manage the property and turn it around. You may know how to add curb appeal and command higher rents. You may have a better exit strategy mapped out. You essentially have an edge over everyone else. If this describes you, you are fundamentally doing what Warren Buffett was doing 40 years ago with stocks. You are in a position to create substantial wealth.

In any given real estate transaction, there is one (maybe a few more) “shareholder” selling to one (maybe a few more) potential “shareholder.” The seller is trying to make the property look as good as possible without the need to adhere to public accounting or SEC standards. At the same time, only a few people (buyers) are diligently analyzing the financials. This practice can leave a lot of room for errors and misunderstandings.

Compare the typical real estate transaction with any company listed on a major exchange and you will see my point – companies have thousands of people analyzing their regulated information and producing reports, ultimately making the market for the company’s shares efficient because almost all data is known, reported on, and consumed. Millions of shares are traded daily, and the bid/ask spread is generally only a fraction of a cent. These markets are operationally efficient, and value-add opportunities are hard to come by.

Conclusion

While there are many factors that make real estate appealing (use of leverage, cash flow, appreciation, economies of scale, etc.), the most attractive factor for me is the inefficiency of the real estate market. The inefficiencies allow savvy investors to find substantial value-add deals even after other investors have passed on the opportunity and to ultimately build wealth.

I must admit that I fear the day when the real estate market becomes efficient. Margins will shrink as competition rises. I personally hope real estate always stays “behind the times.” Can you imagine what the real estate marketplace would look like if someone were able to devise a way to create an efficient exchange (like NYSE) for real estate transactions?

Don’t forget to weigh in: Do you agree? Disagree?

Leave a comment below, and let’s talk!

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About Author

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

22 Comments

Hey Brandon thanks for posting. I don’t see inefficiency as the reason real estate investing is good. Sure you can get good deals here and there, but you do not have the safeguards you have with stocks either. Both can move based on market trends that are not always obvious every time. Making 5 or even10K in value on a purchase with 5 or 10 properties will not make you rick, it will help though. if you buy 10 properties and hold them for 30 years on a good cash flow you will make serious money. real estate often has a much higher rate of return for sustained periods. On top of that try getting a loan for $100K to buy stocks from a bank. The ability to leverage money on real estate is very helpful in building wealth. While it is true you make your money when you buy, for me I make my money when I rent.

Hey Jerry – thanks for reading. I agree with everything you said. The intent of the article was to point out that a savvy investor can take advantage of the market inefficiencies and profit from them. Thanks for your comment!

I think there are ways for the stock market to be inefficient besides informational inefficiency. For example some people may have the same information but draw different conclusions. For example one of the guys he hired Todd Combs made an investment in Visa, back when there was a great deal of uncertainty about the company’s future, this was 2007 or so. Based on your argument, it’s hard to say that he had an informational advantage, he doesn’t talk to management (based on his own admission), and primarily gets his info from the same sources the rest of us use 10k, 10q, industry publications etc. Yet he was able to come to a correct and profitable conclusion about the company. I’ll end with a thought that Charlie Munger has put out there, if your right about the quality of the business then over a long period of time the initial discount (i.e margin of safety or inefficiency) doesn’t matter that much, your overall return will closely mirror the performance of the business. This can be seen in the market performance of BRK stock itself, if you look at the most recent shareholder letter you will see that the book value of the equity has fairly closely mirrored the quoted market price. Just my 2cents.

Hey Robert – thanks for reading and taking the time to post a comment. You are right, there are plenty of ways the market can be inefficient. For this post, I was just speaking on terms of informational and operational inefficiencies. Thanks for reading!

Nice article. Your 100% correct!!! I will say finding deals 50% off the current value in real estate is still very hard to do.

Jerry-
the author is saying that you would find deal 50k + not 10k off what property is worth. Now 50k per deal will make you crazy rich!

Robert
the author is saying that in real estate if it was stock being traded for $7.00 on an exchange a superstar real estate investor could buy it for $5.00(and could sell it the same day for $7.00) The Visa example was speculation on future appreciation.

You can make a few hundred dollars (or a few thousand dollars) quickly, if you know what you are doing, when it comes to the stock market. I have done it. Yes, you can also lose some money, if you wait too long to get out, on a stock that goes down instead of going up. The biggest advantage the stock market has over real estate, is that you can make money in the comfort of your home. Real Estate is ‘visual’ and physical. It’s very risky, buying and selling real estate through the Internet (Ebay), although some people are doing it. Through photos and factual information about a property, you can pick out those you want to go see in person, but visual and physical inspection of any property is a must.

Hey Joe – thanks for reading and commenting. I actually disagree in that I think the biggest advantage the stock market has over real estate is the lowers risk due to liquidity. I do agree that you can make plenty of money if you know what you are doing, but the same can be said for real estate. My argument is that you can make more money in real estate if you are a savvy investor because you can consume the (limited) information better than the next guy. Since there are so few eyes on any one deal, there is a ton of profit potential.

You should also remember that real estate isn’t fungible. If I want to buy shares of Microsoft, I don’t need your particular shares. I can buy anyone’s shares and get the same result. Housing is different because each house is like a snowflake (not to investors, but to homebuyers) so if their wife wants THAT house, not just A house, then the negotiating position changes. And some things can’t be improved. If my house is by the beach and your’s isn’t, then you can’t make the value catch up to mine, even if you put in the same kitchen and floors that I did.

Something you’re not considering with regard to the inefficiencies is the illiquidity and high transaction costs. That’s why you’re getting a bigger return in real estate…because you have to. Closing costs, mortgage fees and taxes are several percentage points. And just because you want to sell and get your money out today, doesn’t mean you will find a buyer right away. With stocks, if I want to get out of Microsoft, I can log on to my brokerage account and get all my money out in a few seconds and the brokerage fee is…$7. So if the returns were the same, you would be nuts to invest in real estate.

And yes, the stock market was VERY inefficient when Buffett got started. He made a lot of his early money by buying shares that weren’t actively traded and so had no price that could be quoted. He literally wrote to stockholders and sometimes visited them in person to talk them into buying their shares.

Hey Peter – thanks for reading and commenting. I didn’t explicitly address liquidity but if you read my posts from the forums, you will see that we are definitely on the same page with pretty much everything you said.

The point of my article was basically to point out that if you are a savvy investor, you can take advantage of the inefficiencies similar to what Buffet did and the reap the benefits.

Absolutely agree. I have made hundreds of thousands of dollars from market inefficiencies. Namely poor listing agents who do not know how to comp a property, how to appropriately market a property, or even negotiate for their client. Thank you ubiquitous short sale / REO agent with specific knowledge of that type of transaction but far less knowledge of actual home, neighborhood, etc. Same for the “out of area” listing agent. Cha Ching! And these are all at a level of MLS listed properties in California in the age of internet exposure. I can only imagine the “good old days”!
Unfortunatley I do think we are trending towards technology proving more market efficiencies than ever before. Probably a good thing overall for consumers, but not as fertile grounds for a professional investor/realtor with deep current market knowledge and willingness to take action on short windows of opportunity.

I want to add one more advantage about real estate industry….I have come across far more non-capable people in this industry than ones with just average skills, let alone with smart ones. It’s easy to get into but very difficult to be considered “good”. Never one deal I come through and everything goes smoothly. Certainly, someone will make mistakes or drop the ball along the way. All that said, it represents even more opportunities than any other industries for someone who are willing to work hard at it.

Real estate also allows you some control over your asset. If I buy stock in McDonald’s there is not much I can do to increase the value of that stock. I can buy a Big Mac for lunch but that’s about it.

A creative person can add value to RE through any number of means from sweat equity to making a duplex of a SFH.

RE puts you in the driver’s seat and takes away your ability to shift the blame for your failures. As a conservative Christian I am a firm believer in personal accountability. That’s why I like RE!

Very solid article. I think markets may become more efficient but the amount of investors will remain low due to barriers to entry. Costs of moving will keep volume low which is on the investors side. The one big thing that hurts RE investors is cost. I can trade a stock for under 10 bucks but with RE commisions and closing costs I will get slammed in a high volume trading environment. Im waiting for the day that costs fall so that more RE investors can exploit market inefficiency in a more cost efficient way. I guess thats one more reason to become an agent if you do multiple deals a year.

Hey Lee – if costs fall, that will definitely make the market more efficient because as you said it will lower the barriers of entry allowing more people to have their eyes on any one transaction. I think if costs fall, margins will surly tighten and make it tougher for the rest of us to snag solid deals.

As access to information increases, what are your thoughts on the realtor’s role? Are they going to be squeezed out of the market?